The Riches of Humility

The average American consumer may be cash-poor, but the average American corporation is not. A few of these cash-rich corporations are spending their money very wisely…by investing in their own shares.

America’s corporate titans are flush with cash. The S&P 500 companies alone hold about $22 trillion in cash equivalents, which represents about 10% of their total assets. Increasingly, many corporations are using their liquid funds to buy back stock. The top 25 S&P 500 companies bought back about 1.6% of their shares last year, at a cost of $60 billion. About half of all S&P 500 companies reduced their share count from the prior year – the highest total we have seen in four years.

For mature, cash-spinning business, the "plain vanilla" stock buyback can be an exceptional way to boost shareholder value. Author Louis Lowenstein calls it a "form of financial humility," because when a management team adopts a regular and significant buyback program, it is essentially admitting that it has no better way to invest the cash – not even in the expansion of its business.

Likewise, boosting dividend payouts represents another form of financial humility. By paying dividends, corporate managements implicitly admit that they can envision no better use of company cash.

We like financial humility…especially in a company whose core operations are performing well.

Sometimes managements try too hard. Over the years, many of the management teams that were blessed with extra cash have devised clever ways of squandering it. They have embarked, for example, on ill-fated plans to acquire flawed competitors or to diversify into unrelated businesses. In the process these managements have wasted money that could have produced a higher return in the service of much less creative endeavors: Buying back stock or paying dividends.

Stock buybacks can be a firm’s best investment, in particular if its shares are trading cheaply. It is an investment in a business that management already knows very well. The Sage of Omaha, Warren Buffet, lays out the advantages of plain vanilla stock buybacks in his 1984 Annual Report:

"The obvious point involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value…Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended."

Investors ought to remember the point about acquisitions. Michael Porter, an accomplished corporate strategist, studied acquisitions between 1950 and 1986 (a universe of over 2,000 acquisitions). The results showed that most acquisitions failed to produce satisfactory returns. Of these acquisitions, about 53% of the acquired businesses were subsequently divested or shutdown. Porter noted that the results were conservative, because corporate honchos quietly buried a number of their failures.

Buy backs are easier to execute well than acquisitions. Nevertheless, insiders often buy their stock at inopportune times. The trick, of course, is to buy the shares when they are cheap. In this, corporate America seems to have used poor judgment at times. In 1982, for example, when U.S. stocks were dirt-cheap, American corporations purchased only one-tenth of one percent of their shares outstanding, or about $2.2 billion worth of stock. Five years later, corporations spent 30 times as much money buying stocks, only to watch their prices crash in October of that year.

The chart below shows the bad timing of the last few years; heavy buying in the late 1990s bubble years and a slowdown in years where it would have been profitable.

The difficult question to answer is this: Are corporations buying back stock because they believe the stock is cheap, or is it simply an exercise in bad timing? Hard to know for sure, but the market’s valuations seem to indicate that in most cases, corporations are tossing shareholder money in the wind.

Most of the poor timing, we suspect, stems from impure motives. Companies often conduct share buybacks that do not advance the interests of ALL shareholders. For example, the "greenmail" paid to hostile suitors to "go away" is obviously unfair to the existing shareholders, who are unable to realize the premium paid to the suitor. Another abuse is when corporate chieftains buy back stock to deceive the market by "keeping up appearances" even when they knew that the business is crumbling on the inside. Other questionable practices include buybacks funded with large amounts of borrowed money, or buybacks used to fund excessive employee stock option plans, etc.

Happily, some companies still conduct "plain vanilla" share buybacks – the type that increases shareholder value. Hudson City Savings is one such company. Public since 1999, the company has repurchased 55 million shares over the last six years, or about half the stock sold in its initial offering! The stock has surged from a split-adjusted $6 to about $35 today — a nearly six-fold return on the original investment!

Sometimes it pays to be humble.

Did You Notice…?By Eric J. Fry

If not for the poor, the rich would struggle to make ends meet.

"Poor countries have become the financiers of the United States," the New York Times observes, "fueling one of the most extravagant consumption drives in world history. From 1996 to 2004, the American current account deficit – which includes the trade deficit as well as net interest and dividend payments – grew to $666 billion from $120 billion, swelling the nation’s demand for foreign financing by $546 billion. "

Somewhat surprisingly, "developing countries" are providing most of this cash.

"The current accounts of developing countries swung from a deficit of $88 billion in 1996," the New York Times continues, "to a surplus of $336 billion last year – a $424 billion change that has covered some four-fifths of the increase in the deficit of the United States."

We rich Americans are not stealing the money, of course. The poor are providing the funds of their own free will. Even so, the phenomenon feels a bit perverse. (Imagine walking up to a homeless person and asking for a loan). It also feels unsustainable. And if the wellspring of borrowed money were to run dry, we rich might begin to feel much more poor than our "poor" creditors.

"Conventional economic thought suggests that funds should flow the other way," the Times correctly observes. "Capital-rich industrial nations like the United States, where workers already have a large stock of capital goods to work with – like high-tech factories and advanced information technology networks – should be sending money to places rich in labor but with a meager capital stock."

For as long as funds are flowing in the "wrong" direction, we Americans may continue to enjoy our dubious prosperity. But woe to us if funds begin flowing the "right" way!

"For the developing world to be lending large sums on net to the mature industrial economies is quite undesirable as a long-run proposition," says Fed Governor Ben Bernanke.

About Chris Mayer:

Chris Mayer is a financial analyst with Bonner & Partners. He has been quoted many times by MarketWatch and has been a guest on Forbes on Fox, Fox Business and CNN Radio, and has made multiple CNBC and radio appearances. He’s also contributed to The Washington Post. Chris travels the world looking for great ideas and insights for his readers.